As the real estate market has changed in the last year, many homeowners are starting to have problems meeting their mortgage. Short sales are touted as a solution, but you must consider taxes before doing it.

Mortgage Relief, Short Sales and Taxes

Lenders have been criticized for the last few years for creating loan programs that set borrowers up for trouble. These programs came in many forms, but interest only, zero down and various hybrid loans were the chief programs criticized. Specifically, critics charged that these loans would lead to disaster when housing prices eventually corrected and interest rates rose from their historic lows.

Well, it appears as though the criticism was correct. We are just starting to see a trend where many homeowners are staring a mortgage nightmare in the face. What is the nightmare? They are upside down on their homes and cannot afford the mortgage payments. Many people have borrowed beyond the equity in their home. If they haven't, they may have taken on a debt that they cannot afford to service, to wit, make the month payments. At the outset of the loan, they had no problem with the payments. As the initial teaser rate periods have ended and interest rates have risen, they are feeling the pinch. Frankly, this trend is going to grow over 2007, which should be a banner year for loan defaults.

One solution for the above scenario is to pursue a short sale. A short sale occurs when a lender agrees to let you sell the home for less than you owe. Realizing you are headed for foreclosure, the lender basically takes its licks and walks away from the situation. Various companies suggest this is an easy solution, but you need to understand most lenders will not be receptive to this strategy. Instead, they will offer to modify the terms of your loan or forebear payments for a few months. Still, what if they agree to a short sale? Short sales sound like the perfect solution for most borrowers in over their heads. There is, however, a potential nasty trap out there - taxes. In certain situations, the IRS will view your release from the mortgage debt as a taxable event and expect you to pay income taxes on the amount in question.

Contrary to the commercials you see and hear, this is not an automatic occurrence. Instead, there is a particular formula you can use. To figure out if you are going to have to pay income taxes from a short sale, you need to focus on the tax basis and the amount you owe at the short sale. The tax basis is simply your purchase price plus any capital expenses such as home improvements. Assume you buy a home for $500,000 and put $100,000 into it in improvements. Assume you refinance a few times and owe $500,000. Your tax basis is $600,000, which is more than you owe. In such a scenario, you will not have to pay income tax on the short sale relief. For most people, however, this is not the case. Assume you purchased a home in 2002 for $300,000 and it appreciated to $500,000. Along the way, you refinanced a couple of times and sucked cash out. You now have a mortgage for $450,000 and are in trouble with the payments. The lender agrees to a short sale and you sell the home. You now have a large tax problem. Your tax basis is $300,000, but you owed $450,000 on it at the time of the sale. In the view of the IRS, the $150,000 debt relief is a form of income to you. You now must report and pay income taxes on $150,000 even though you didn't put a red penny in your pocket. Talk about a nightmare!

If you are having problems meeting your mortgage obligations, it is important that you do not panic. Talk with your lender about your options. If a short sale looks like the solution, make sure you sit down with an accountant before selling. While defaulting on a mortgage is unfortunate, creating a tax nightmare is definitely worse.

Dan Lewis is with Great Western Mortgage - providing San Diego mortgage loans for new purchases, refinance and more.
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